Updated: Jan 18
Let's get this straight... Often professional traders teach how to make adjustments on your positions for a high fee and not always say all the truth.
Right here, I am going to share with you the basics of options adjustments on one of the most rewarding strategies, the long straddle. By the end of this article, you should be fully aware of the reasons why is so important making adjustments and be able to easily place them on straddles when a stock price fluctuates.
I tried to make this article short, but it just was too much information. I hope you can forgive me for this.
Have you ever heard of stock options adjustments?
When trading a complex option strategy such as a straddle, you may find yourself in several different scenarios in which may be vital making adjustments on your trade.
A long straddle strategy is performed for a certain number of reasons. For the survival in the marketplace, it is essential that traders keep in mind their whys in order to make the right decisions when the market conditions change.
Adjustments on Straddles
Anytime you enter a straddle, you should be able to make up a position with delta 0. It means that both calls and puts purchased should be as much ATM as possible. The optimal scenario comes when the options strikes are exactly at the same level of the stock price.
As time goes through, it may likely happen that the stock price gets further from the option strikes purchased. Consequently, if the stock price rises the delta becomes as much positive as more the stock increases its value. Conversely, if the stock price decreases, the delta becomes as much negative as more the stock falls.
At this point remember that the main reason you decided to open the position was an upcoming catalyst event. If this event is to happen yet, you should consider adjusting your position so as to bring the delta back to 0. In order to do so, you need to buy or sell more financial instruments (puts, calls or stocks) and bring back to 0 the delta of the trade as a whole.
How delta is Influenced by a change in the stock price
Let us get into a straddle to check this process. Imagine you buy XYZ ATM calls and puts at $35 with the stock price trading at $35. This is an ideal scenario in which your delta is at the beginning perfectly equal to 0 (in reality, the delta will be slightly positive or negative depending on how much close to the stock price is the strike purchased).
As time moves on there may be three different scenarios. The stock price may:
Be stuck around $35; your delta can be slightly positive or negative, but you are still neutral if compared to the trade direction.
Move upward (say at $37); imagine your delta becomes positive for 100 points, meaning that you are not anymore completely neutral respect the direction, but you are becoming bullish.
Move downward (say at $33); imagine your delta becomes negative -100 points, meaning that you are not anymore completely neutral respect the direction, but you are becoming bearish.
In the last two scenarios, if you don’t make a promptly decision to adjust the position, your trade becomes directional and, as a result, the straddle may have less chances to be profitable.
What is the risk involved in not performing an adjustment?
The 2nd and 3rd scenarios involve a high risk in a delta neutral trade. Once again,
you must keep in mind that your purpose is to benefit from an incoming event. You don’t know in which direction such event will affect the stock, but you are extremely confident that it is going to have an effect.
In the previous example, assuming the two breakeven points at respectively $31 and $39, let’s see what might happen if you decided not to adjust your position.
When the awaited event comes the stock may move explosively either upward or downward.
In the 2nd scenario (stock moving upward to $37 and +100 points of delta):
You may collect a reasonable profit if the stock price went up $5 to $42 in the day of the catalyst event (e.g. earnings release).
You may collect a loss if in the same day the stock price went down $5 to $32.
While, in the first case you are above the higher breakeven; in the second case you are within the breakeven points and may get a loss depending on the time value remaining and the implied volatility of the options owned.
In the 3rd scenario (stock moving downward to $33 and -100 points of delta):
You may collect a reasonable profit if that day the stock price went down $5 to $28.
You may collect a loss if in the same day of the catalyst event the stock price went up $5 to $38.
While, in the first case you are below the higher breakeven; in the second case you are within the breakeven points and, once again, may get a loss depending on the time value remaining and the implied volatility of the options owned.
How to make adjustments to delta 0
In order to avoid collecting such a loss, make the decision to adjust your position bringing the trade back to delta 0. By doing so, you are pursuing your goal to collect a profit any direction the underlying moves.
With the breakeven points at $31 and $39, a rise of $5 in the underlying would bring the stock to $40 and a fall of the same amount to $30.
Clearly, this example is simplified and doesn’t take into consideration the effect of time decay. In fact, as ATM options carry a lot of time value, the passage of time negatively affects your position.
Rule of thumb: never hold a long straddle into the last month before expiration. In fact, this is when the time decay effect is at its fastest rate hurting irreparably your position.
If you trade a straddle and offset it when there are still many days left before expiration, you may collect a slight profit even if the stock doesn’t reach the breakeven points. To better understand this process, you should simulate a straddle in the “Analyze Tab” in ThinkorSwim or in an options analysis software and check what happens when price and time change.
In the two scenarios above mentioned, you can easily adjust your position by buying or selling more options or stocks.
1st scenario (stock moving upward to $37 and +100 points of delta).
If your position has become bullish, you can balance the delta by alternatively buying more puts, selling more calls or selling more stocks.
Look at all puts in the options chain/tables and check for the deltas contained in each option. As puts have negative deltas, buy a number of puts whose deltas are equal to -100 to balance the overall position. For instance, if you pick puts with strike $37 and each put has -20 deltas, you must buy 5 puts to reach -100 deltas.
Look at all calls in the options chain/tables and check for deltas. As calls have positive deltas, sell a number of calls whose deltas are equal to +100. For instance, if you pick calls with strike $36 and each call has +17 deltas, you must sell 6 calls to have -102 deltas.
Look at the underlying security. As each stock carries +1 delta, you should sell 100 stocks as to get a number of deltas equal to -100.
2rd scenario (stock moving downward to $33 and -100 points of delta).
If your position has become bearish, you can balance the delta by alternatively buying more calls, selling more puts or buying more stocks.
Look at all calls in the options chain/tables and check for the deltas contained in each option. As calls have positive deltas, buy a number of calls whose deltas are equal to +100. For instance, if you pick calls with strike $34 and each call has +10 delta, you must buy 10 calls to have +100 deltas.
Look at all puts in the options chain/tables and check for deltas. As puts have negative deltas, sell a number of puts whose deltas are equal to -100. For instance, if you pick puts with strike $32 and each put has -12.5 deltas, you must sell 8 puts to have +100 deltas.
Look at the underlying security. As each stock carries +1 delta, you should buy 10 stocks as to get a number of deltas equal to +10.
In each scenario, the final result is to go back to a delta neutral position. It is a merely mathematical calculation in which you need to buy or sell more financial instruments in order to get back to delta 0.
Your purpose is to try to have your straddle close to 0 when the event you are waiting for approaches. In a delta neutral strategy, traders must focus on the catalyst event that is going to happen.
If for example you open a straddle 30 days before an earnings release, you should try to keep your position as more neutral as you can as such event gets closer and closer. Obviously, if the underlying started moving in one direction before the event, you may choose to close your trade earlier collecting a profit.
Please consider that all numbers in the above examples are merely showed by way of explanation.